Grandfather Rule | Nationality of Corporations | General Principles | Corporations | BUSINESS ORGANIZATIONS

Nationality of Corporations: The Grandfather Rule

In the context of Philippine corporate law, determining the nationality of a corporation is critical in situations where the law imposes restrictions on foreign ownership, such as in land ownership, natural resources, public utilities, and certain industries like mass media and advertising. The Grandfather Rule is one of the methods used to determine the "true" nationality of a corporation, particularly in cases where ownership structures are complex and involve multiple layers of corporate entities.

I. Relevant Legal Provisions

1. 1987 Philippine Constitution

   • The Constitution provides specific limitations on foreign ownership in certain areas, such as:
     • Land ownership: Only Filipino citizens or corporations with at least 60% Filipino ownership may own land (Art. XII, Sec. 7).
     • Operation of public utilities: Only corporations that are at least 60% Filipino-owned may operate public utilities (Art. XII, Sec. 11).
     • Exploration, development, and utilization of natural resources: Limited to Filipino citizens or corporations with at least 60% Filipino equity (Art. XII, Sec. 2).

2. Foreign Investments Act of 1991 (RA 7042, as amended by RA 8179)

   • This law reiterates the restrictions on foreign ownership of certain industries and provides guidelines for determining corporate nationality.

3. Implementing Rules and Regulations (IRR) of the Foreign Investments Act

   • The IRR provides further details on how the nationality of a corporation should be determined, particularly through the application of the Control Test and the Grandfather Rule.

II. Control Test vs. Grandfather Rule

1. Control Test (Primary Rule)

   • Under the Control Test, a corporation is considered a Filipino corporation if at least 60% of its outstanding capital stock is owned by Filipino citizens. This is a straightforward test of equity ownership, and it is generally the rule used in most cases.

2. Grandfather Rule (Supplementary Test)

   • The Grandfather Rule is a more nuanced and detailed method of determining the true nationality of a corporation, especially in cases where ownership involves multiple layers of corporations, some of which may have foreign shareholders.
   • The rule "looks through" the corporate structure to determine the nationality of stockholders in each layer of ownership, ultimately determining how much of the corporation is truly Filipino-owned.

III. When is the Grandfather Rule Applied?

The Grandfather Rule is typically applied in the following cases:

1. Where the 60-40 ownership split is met only nominally but the control of the corporation appears to be in the hands of foreign interests. This is often referred to as the "doubtful" or "circumventive" ownership situation.
2. When a corporation’s capital is divided among several tiers of corporate entities, some of which are foreign, making the application of the straightforward Control Test insufficient or misleading.

IV. Mechanics of the Grandfather Rule

1. Tracing Ownership

   • The Grandfather Rule works by tracing the ownership of each shareholder to determine the ultimate ownership of the corporation.
   • In cases where a corporation (Corporation A) owns shares in another corporation (Corporation B), the Grandfather Rule looks at the shareholders of Corporation A to determine the true ownership of the shares held by Corporation A in Corporation B.

   Example:

   • Corporation A owns 60% of Corporation B, and Corporation A has a Filipino shareholder owning 50% of its stock and a foreign shareholder owning the remaining 50%.
   • Under the Grandfather Rule, only 30% of Corporation B would be considered Filipino-owned (i.e., 60% * 50% = 30%).

2. Layered Ownership

   • If there are multiple layers of ownership, the Grandfather Rule is applied recursively, meaning that each layer of ownership is examined until the nationality of the ultimate beneficial owners is ascertained.
   • This tracing ensures that the constitutional or statutory ownership requirements are not circumvented by layering corporations to conceal foreign control.

V. Jurisprudence on the Grandfather Rule

1. SEC Opinions and Rulings

   • The Securities and Exchange Commission (SEC) has issued several opinions clarifying the application of the Grandfather Rule.
   • In some cases, the SEC applies the Grandfather Rule directly, while in others, it has opted for the Control Test as the default rule, reserving the Grandfather Rule for situations where foreign control is suspected.

2. Land Bank of the Philippines v. CA (G.R. No. 127181, October 6, 2000)

   • In this case, the Supreme Court ruled that when determining corporate nationality, the Control Test should be the primary method, and the Grandfather Rule should be applied only as a supplementary rule.
   • The Court emphasized that the Grandfather Rule should be used when there is a need to "pierce the veil of corporate fiction" to reveal the true nationality of the controlling stockholders.

3. SEC Opinions on Tiered Ownership

   • In SEC rulings where multi-tiered corporate ownership is present, the Grandfather Rule has been applied to prevent foreigners from indirectly gaining control over corporations that are constitutionally reserved for Filipino citizens or corporations.

VI. Application of the Grandfather Rule: Key Considerations

1. Purpose of the Grandfather Rule

   • The Grandfather Rule is used to prevent foreign nationals from circumventing the Constitution and other laws restricting foreign ownership in certain industries. It ensures that ownership and control rest truly with Filipino citizens, even if the corporate structure appears to comply nominally with the 60-40 rule.

2. Interpretation by Regulatory Bodies

   • The application of the Grandfather Rule depends largely on the discretion of regulatory bodies like the SEC. If there is a reasonable suspicion that the foreign equity exceeds the allowable limit, the SEC may invoke the Grandfather Rule to determine the actual ownership.

3. Incorporation of the Grandfather Rule in the SEC Rules

   • The SEC has adopted the Grandfather Rule in cases where the Control Test alone may lead to an incorrect determination of nationality, particularly in the context of land ownership, public utilities, and other areas with strict foreign ownership limits.

VII. Conclusion

The Grandfather Rule serves as an important safeguard in determining the nationality of corporations in the Philippines, particularly in areas where the Constitution and laws restrict foreign ownership. While the Control Test is the primary method for determining corporate nationality, the Grandfather Rule acts as a supplementary rule, ensuring that ownership and control truly reflect the intent of the law. The rule prevents foreign nationals from using layered corporate structures to circumvent restrictions on foreign participation in key industries, thereby protecting the interests of Filipino citizens and upholding the country's constitutional mandates.

The Grandfather Rule's application requires careful scrutiny of corporate structures and ownership, and regulatory bodies such as the SEC are entrusted with the task of applying the rule when necessary to ensure compliance with the law.

Control Test | Nationality of Corporations | General Principles | Corporations | BUSINESS ORGANIZATIONS

Nationality of Corporations: Control Test

1. Constitutional and Statutory Framework

The nationality of corporations is a critical concept in Philippine law, particularly due to the constitutional and statutory restrictions on the ownership and operation of certain businesses and properties by foreign entities. The Constitution of the Philippines limits foreign participation in various sectors such as land ownership, natural resources, public utilities, educational institutions, and mass media.

Constitutional Provisions:

• Article XII, Section 2 of the 1987 Philippine Constitution provides that the exploration, development, and utilization of natural resources shall be under the full control and supervision of the State and that foreign ownership should not exceed 40%.
• Article XII, Section 11 states that no franchise, certificate, or authorization for the operation of a public utility shall be granted except to citizens of the Philippines or corporations where at least 60% of the capital is owned by Filipino citizens.

The statutory provisions on nationality requirements can be found in various laws like the Foreign Investments Act (RA 7042) and Republic Act No. 8179 amending the Foreign Investments Act, which specifies that businesses wholly or partially owned by foreign entities are restricted from engaging in activities that fall under the Philippine Constitution’s Foreign Investment Negative List (FINL).

2. The "Control Test" – Doctrine Overview

In determining the nationality of a corporation for purposes of compliance with the Constitution and other laws restricting foreign ownership, Philippine jurisprudence has adopted the Control Test (also referred to as the "Grandfather Rule" when used in certain contexts).

Under the Control Test, the nationality of a corporation is determined by the nationality of the stockholders who control the corporation. The test emphasizes the actual control of the corporation, and not merely the formal legal structure. The basic tenet of this rule is that the corporation's citizenship is aligned with that of the controlling shareholders.

The Supreme Court of the Philippines, in several cases, has expounded upon this principle, emphasizing that it is the actual control that should dictate whether the corporation is Filipino or foreign.

Landmark Case: Narra Nickel Mining v. Redmont Consolidated Mines (G.R. No. 195580, April 21, 2014)

One of the key cases that reinforced the application of the Control Test is Narra Nickel Mining and Development Corp. v. Redmont Consolidated Mines Corp. This case involved a dispute over the nationality of a mining corporation engaged in the extraction of natural resources, an activity reserved exclusively for Filipino citizens or corporations that are at least 60% Filipino-owned.

In this case, the Supreme Court ruled that the Control Test takes precedence over the Grandfather Rule in determining the nationality of a corporation. The Court rejected the argument that foreign shareholders holding minority ownership could exercise control through indirect means. Instead, it emphasized that control refers to both the ownership and management of the corporation.

The Control Test looks at the corporate governance structure, including the composition of the board of directors and the officers of the corporation. Even if a corporation is formally compliant with the 60-40 rule on the face of stock ownership, it can still be deemed foreign if it can be shown that foreign nationals exercise control over the corporation through voting power or influence over decision-making processes.

3. The Grandfather Rule vs. Control Test

While the Control Test is the prevailing doctrine, there are instances when the Grandfather Rule (or the "piercing the veil of corporate fiction" rule) is invoked to supplement or further clarify the nationality determination.

Grandfather Rule Defined

The Grandfather Rule involves tracing the nationality of shareholders through layers of ownership. If a Filipino-owned corporation is in turn owned by another corporation, which has foreign shareholders, the rule requires looking beyond the nominal ownership to the underlying layers to determine whether the foreign shareholders ultimately control the company.

For example, a corporation may appear to be 60% Filipino-owned, but the Grandfather Rule would trace the ownership of the 60% Filipino shareholders. If these Filipino shareholders are found to be mere dummies for foreign nationals, the corporation will be treated as foreign.

Control Test vs. Grandfather Rule in Practice

• The Control Test is generally the preferred method in determining the nationality of a corporation. It simplifies the determination by focusing on effective control at the operational level, which is often evidenced by who controls the corporate board and decision-making power.
• The Grandfather Rule is invoked when there is suspicion that the formal application of the Control Test is being circumvented through layers of corporate ownership to mask the true identity of the shareholders or ultimate control.

The Supreme Court has clarified that the Grandfather Rule is not automatically applied but is instead used to pierce the veil of corporate fiction when there is sufficient evidence of corporate structuring meant to evade nationality restrictions.

4. Key Considerations in Applying the Control Test

When determining control, the following factors are generally considered:

• Ownership of voting shares: A simple majority of 60% of the capital stock is owned by Filipino citizens.
• Management and decision-making: The composition of the board of directors and corporate officers (president, treasurer, etc.) must be predominantly Filipino to align with the ownership structure.
• Corporate control and influence: Even if 60% of the capital stock is Filipino-owned, foreign nationals cannot exercise controlling influence over the corporation's policies and operations.

5. Practical Implications for Corporations

Corporations that engage in activities subject to nationality restrictions must ensure that they comply with the Control Test and constitutional requirements. This involves:

• Structuring ownership to ensure compliance with the 60-40 rule.
• Ensuring that control at the level of the board of directors and key officers is exercised by Filipinos.
• Being prepared for potential challenges invoking the Grandfather Rule if foreign nationals are suspected of circumventing nationality restrictions through complex ownership structures.

6. Conclusion

The Control Test is the dominant method for determining the nationality of a corporation under Philippine law. It emphasizes actual control over nominal ownership and is used to ensure compliance with constitutional restrictions on foreign participation in certain sectors. While the Grandfather Rule can be applied to supplement this test, its application is more limited and is generally invoked only when there is suspicion of evasion of the nationality restrictions. Corporations must carefully structure both ownership and management to align with the requirements and avoid potential legal issues.

Nationality of Corporations | General Principles | Corporations | BUSINESS ORGANIZATIONS

Nationality of Corporations: General Principles Under Philippine Law

The nationality of a corporation is a significant legal consideration in the Philippines, particularly because of the various constitutional and statutory restrictions on foreign ownership and participation in specific sectors of the economy. Determining whether a corporation is considered "Filipino" or "foreign" is critical for compliance with the Philippine Constitution, the Foreign Investments Act (FIA), and other regulatory laws. Below is an in-depth and meticulous explanation of the relevant principles surrounding the nationality of corporations in the Philippines.

I. Constitutional and Statutory Framework

1. Constitutional Restrictions on Foreign Ownership The 1987 Philippine Constitution limits foreign ownership in certain areas of investment. Among the most significant provisions are:

   • Public Utilities: Article XII, Section 11 of the Constitution limits foreign equity participation in public utilities to a maximum of 40%, meaning that at least 60% of the capital must be owned by Filipino citizens or Filipino corporations.
   • Natural Resources: Under Article XII, Section 2 of the Constitution, foreign ownership in corporations engaged in the exploration, development, and utilization of natural resources is limited to 40%.
   • Media: Article XVI, Section 11 mandates that ownership and management of mass media be wholly owned by Filipino citizens or Filipino-controlled corporations (100% Filipino ownership).
   • Land Ownership: Only Filipino citizens or corporations at least 60% owned by Filipinos may own private land in the Philippines (Article XII, Section 7).

2. Foreign Investments Act of 1991 (RA 7042 as amended by RA 8179) The Foreign Investments Act (FIA) defines restrictions on foreign equity in certain sectors through the Foreign Investment Negative List (FINL). Certain industries are restricted to full Filipino ownership, while others are subject to a maximum foreign equity cap (usually 40%).

II. Control Test and Grandfather Rule

The nationality of a corporation in the Philippines is generally determined by the application of two primary legal doctrines: the Control Test and the Grandfather Rule.

1. Control Test The Control Test is the primary rule used to determine the nationality of a corporation. This test evaluates the ownership of shares with voting rights and control over the corporation. If at least 60% of the outstanding capital stock entitled to vote is owned by Filipino citizens or Filipino-controlled corporations, the corporation is considered a Filipino corporation.

   • Example: If Corporation A has a total of 100 shares, 60 of which are owned by Filipino citizens, the corporation is considered Filipino, regardless of the foreign ownership of the remaining 40 shares.

   The Control Test is favored because it promotes simplicity in determining corporate nationality, focusing on the controlling interest in the corporation. The test was affirmed by the Philippine Supreme Court in the landmark case Narvacan v. Court of Appeals (G.R. No. 93605, May 18, 1993), where the Court emphasized the importance of "beneficial control" rather than just the formal ownership of shares.

2. Grandfather Rule The Grandfather Rule is an alternative method used when there is a need to look beyond the superficial ownership of shares. This rule traces the ultimate ownership of shares to the individual level to determine whether foreign interests hold actual control over a corporation. It is applied where there is a "doubt" about the real nationality of a corporation, especially when there are layers of corporate ownership involved.

   • Mechanics: The Grandfather Rule operates by "piercing the veil" of corporate structures and examining the actual beneficial ownership of shares. If a corporation's shareholders include other corporations, and those corporations are partly foreign-owned, the foreign ownership of these corporations is traced to the individual stockholders to determine the actual foreign interest.

   • Example: If a Filipino corporation (Corp B) owns 60% of another corporation (Corp C), but Corp B is 50% foreign-owned, the Grandfather Rule traces Corp B's foreign equity to Corp C. Corp C would be considered only 30% Filipino-owned (60% × 50%), which would disqualify it from being considered a Filipino corporation if the Grandfather Rule were applied.

3. Supreme Court Jurisprudence on the Control Test and Grandfather Rule The leading case that clarifies the relationship between the Control Test and the Grandfather Rule is Gamboa v. Teves (G.R. No. 176579, October 9, 2012). In this case, the Supreme Court ruled that the Control Test should be the primary standard for determining the nationality of a corporation. However, when there is doubt about the true nationality or when ownership is diluted through layers of intermediate corporate ownership, the Grandfather Rule may be applied.

   The Supreme Court further explained that for corporations engaged in constitutionally restricted activities (e.g., utilities), the 60-40 Filipino-foreign equity structure must reflect "full beneficial ownership and control" by Filipinos. Merely holding shares nominally in favor of foreigners would not satisfy the requirements of the Constitution.

III. Layered Corporate Ownership and the Application of Nationality Tests

The complexity of corporate structures often necessitates a careful application of both the Control Test and the Grandfather Rule. The application becomes particularly intricate in situations where corporations own shares in other corporations, creating layers of ownership.

• First Layer of Ownership: The Control Test is first applied to assess whether at least 60% of the outstanding voting shares in the first corporation are owned by Filipino citizens or Filipino-controlled corporations.
• Second Layer of Ownership: When a corporation is owned by another corporation, the Grandfather Rule may be triggered to determine the true beneficial ownership. The rule traces through layers of ownership to ensure that the Filipino majority requirement is not undermined through complex corporate structuring or nominal ownership.

IV. Special Cases and Considerations

1. Dummy Corporations The use of "dummy corporations" to evade nationality restrictions is prohibited under Philippine law. Dummy arrangements involve Filipino citizens nominally holding shares for the benefit of foreign investors. Such arrangements may be voided, and parties involved may be subject to penalties under the Anti-Dummy Law (Commonwealth Act No. 108, as amended). Violations may result in imprisonment, fines, or the cancellation of licenses to operate.

2. Preferential Rights for Filipino Corporations Filipino corporations often enjoy preferential rights in sectors like public utilities, mining, and agriculture. For example, Filipino-owned corporations may participate in contracts with the government for the development of natural resources under the Mining Act of 1995 (RA 7942) or the Build-Operate-Transfer Law (RA 6957).

3. Foreign Corporations and Licensing Foreign corporations wishing to do business in the Philippines must obtain a license from the Securities and Exchange Commission (SEC). These corporations are generally prohibited from engaging in activities reserved for Filipino-owned corporations unless they comply with applicable foreign ownership limits.

V. Role of the Securities and Exchange Commission (SEC)

The Securities and Exchange Commission (SEC) plays a crucial role in determining corporate nationality. When corporations register with the SEC, they are required to disclose the ownership of shares to verify compliance with the nationality restrictions under the Constitution and applicable laws. The SEC may conduct investigations and audits of corporate records to ensure the proper application of the Control Test and Grandfather Rule.

In 2013, following the Gamboa ruling, the SEC issued Memorandum Circular No. 8, Series of 2013, which provides the guidelines for determining the nationality of corporations. The Circular codifies the procedures for applying the Control Test and, where necessary, the Grandfather Rule, especially for corporations engaged in constitutionally restricted industries.

VI. Conclusion

The nationality of a corporation in the Philippines is a vital consideration in ensuring compliance with constitutional and statutory limits on foreign ownership. The Control Test is the primary method used to determine nationality, focusing on ownership of voting shares. However, the Grandfather Rule may be applied in cases of doubt, particularly in complex corporate structures, to trace the actual beneficial ownership and control by foreign investors. Both rules are critical in safeguarding the constitutional mandate of promoting Filipino participation in strategic industries and ensuring that national assets remain under the control of Filipinos.

The consistent interpretation and enforcement of these principles by the Philippine Supreme Court and the Securities and Exchange Commission ensure the effective regulation of corporate ownership in the country.